Firms traditionally have issued conventional securities such as straight debt and common stock in order to raise capital. In general, straight debt securities (e.g., bonds, notes, loans, mortgages) raise capital by borrowing and promising to repay a principal amount and interest on a specified future date. Common stock securities, on the other hand, raise capital by selling an equity interest in the firm.
In addition to conventional types of securities, firms also have a variety of more sophisticated investment instruments at their disposal. These hybrid securities often combine attributes of several different types of securities (e.g., debt components and equity components) and may change optionally or automatically at certain points in time or depending on market conditions. Convertible securities, such as convertible debt, for instance, provide the issuer and/or the holder with the option of exchanging the convertible securities for other securities, such as common stock. Convertible securities may be priced at a premium, yet may be attractive to investors due to their mix of features, such as earning interest like bonds when the stock price is down or flat and increasing in value like common stock when the stock price rises.
New forms of hybrid capital instruments include instruments that are structured as debt for all purposes (e.g., tax, GAAP), yet receive some measure of equity credit from various credit rating agencies (in particular, Standard & Poors Ratings Services, Moody's Investors Service and Fitch Ratings). While a number of different structural features can be included in these hybrid securities to achieve differing levels of equity credit, there are some core features that are common to all of these hybrid securities. These common features include deep subordination, long-dated maturities (e.g., 60-year legal maturity) and the ability to defer coupon payments on the hybrid security (e.g., 10 years of optional deferral).
Generally, these hybrid securities are callable by the issuer prior to their legal maturity. If a hybrid security is callable, the issuer of the hybrid security has the right, but not the obligation, to repurchase the hybrid security at a specified price at some point in the future. These hybrid securities may also be convertible by the investor of the hybrid securities prior to their legal maturity. If a hybrid security is convertible, the investor also has the right, but not the obligation, to convert the hybrid securities to some other security or cash at a specified price at some point in the future.
One type of hybrid security is one that has a so-called “replacement capital covenant” (“RCC”). An RCC is a legally enforceable covenant entered into by the issuer of the hybrid securities to issue additional securities to replace the hybrid securities at some point in time, such as a number of years after the issuance of the hybrid securities, if the hybrid securities have been called by the issuer. Again, an RCC can typically be found in the prospectus, offering memorandum, indenture or a similar document for the issued hybrid security.
A different type of hybrid security is a hybrid security with a so-called “replacement capital intention” (“RCI”). An RCI is a stated intention by the issuer of the hybrid securities to issue additional securities to replace the issued hybrid securities if the hybrid securities have been called by the issuer. Such an RCI is typically not legally enforceable and can usually be found in the prospectus, offering memorandum, indenture or a similar document for the issued hybrid security.
To satisfy the RCC, the issuer must issue replacement securities before calling the hybrid securities, where the replacement securities give the issuer the same amount of equity credit as contained in the called hybrid securities. The issuance of the replacement securities must occur during a specified period of time prior to calling the hybrid securities, typically 180 days, in order to satisfy the RCC. For hybrid securities that include an RCI instead of an RCC, the RCI may also have a requirement that replacement securities must be issued prior to the calling of the hybrid securities, but any requirements found under the RCI are typically less formal than those found under an RCC because only the RCC is legally enforceable. If the issuer calls the hybrid securities without issuing the replacement securities prior to calling the hybrid securities, the issuer has breached the RCC or the RCI, as the case may be, depending on which clause the hybrid security contains. A breach of the RCI may negatively affect the issuer's credit rating, although, as mentioned above, it is not ordinarily legally enforceable. A breach of an RCC, in addition to negatively affecting the issuer's credit raring, may be legally enforceable.
Often these callable hybrid securities will also have no-call periods. A non-call period is a time period where the issuer is prohibited from calling the hybrid security. Often the non-call period is at the beginning of the term of the hybrid security. For example, for a sixty year term hybrid security, a non-call period may extend from the issue date of the hybrid security to some point in time in the future, such as five or ten years after the issue date.
In addition, hybrid securities are often deeply subordinated. Because hybrid securities often combine attributes of debt and equity, their treatment, for subordination purposes, also takes into account the subordination features of debt and equity. For example, these hybrid securities are often junior to every piece of outstanding debt the issuer has but would be senior to the equity shareholders.